Dollarization - the holding by residents of a substantial portion of their assets in foreign-currency-denominated assets- is a common feature of developing and transition economies, and therefore typical of many countries with IMF - supported adjustment programs. This paper analyzes policy issues that arise-and various monetary strategies that may be pursued- when the monetary sector is dollarized, and it considers the implications that dollarization has for the design of IMF programs.

The phenomenon of dollarization poses a challenge to the pursuit of a coherent and independent monetary policy. In responding to this challenge, the authorities must address two key questions about the conduct of monetary policy. What is the most appropriate exchange rate/monetary policy regime? What monetary target should the authorities pursue (in particular, should dollar-denominated assets be included in an intermediate target)? This section addresses these two questions in turn. To organize ideas, it is useful to discuss the cases of currency substitution and asset substitution separately, while bearing in mind that in practice the two may coexist. Currency substitution would in general be accompanied by asset substitution, since it is natural to hold financial assets denominated in the transaction currency. In contrast, asset substitution does not necessarily involve currency substitution.

Exchange Rate Regime

The theoretical literature suggests that a key implication of currency substitution is that the volatility of a floating exchange rate will tend to be greater. First, there may be frequent and unexpected shifts in the use of domestic and foreign money for transaction purposes. Because the two currencies serve essentially the same purpose, the public may shift between them for a number of not easily identifiable reasons.20 Second, domestic money demand (the demand for the domestic component of the monetary aggregate) will be more sensitive to changes in its expected opportunity cost. In addition to the usual effect of interest rates on overall money demand, the domestic component of money will also be affected by changes in its opportunity cost relative to foreign money. In other words, the interest elasticity of domestic money demand will be higher when currency substitution is significant. While the implications of this higher interest elasticity depend in a complex way on the structure of the economy, one important effect is that in a floating-rate system, the exchange rate will be more sensitive to expected changes in the domestic money supply and other variables that affect the money market. The higher elasticity may also have the opposite effect, however, for different types of shocks. For example, a given random shock to current money demand will have smaller overall effects, since smaller changes in the exchange rate and interest rates would be required to bring the money market back into equilibrium.

A clear case for fixing the exchange rate in a highly dollarized economy is when stabilizing from very high inflation or hyperinflation. Currency substitution is likely to be important, and monetary shocks are likely to predominate, especially because successful stabilization may result in a large but unpredictable increase in demand for domestic currency. Moreover, in a hyperinflation, foreign currency may assume the role of unit of account, and the exchange rate may also serve as an approximate measure of the price level, which would make the role of fixing the exchange rate very powerful in guiding expectations toward a low-inflation equilibrium. The stabilization from hyperinflation in Argentina in 1991 and in Croatia in 1994 are examples where an exchange rate anchor helped to stop inflation in its tracks within the context of extensive currency substitution.21

Dollarization in the sense of asset substitution alone does not directly affect a narrow definition of money demand. The availability of dollar deposits in domestic banks, however, has several implications for monetary policy. The most important for the choice of exchange rate regimes may be that the availability of dollar deposits in domestic banks also serves to increase capital mobility, since the public can potentially shift between dollar-denominated deposits held with domestic banks and abroad, and between dollar- and domestic-currency-denominated deposits held with domestic banks. These different assets are likely to be close substitutes from the point of view of savers, and this in turn strengthens the links between interest rates in dollar deposits at home, international dollar interest rates, and domestic currency interest rates. This would limit the control that the central bank can exert on monetary conditions, such as the level of interest rates on domestic currency. In this respect, a flexible exchange arrangement may be a useful device to increase monetary autonomy, which somewhat contradicts the general recommendation in the currency substitution case.

It is in principle possible to make a judgment about the extent to which dollarization represents currency substitution rather than asset substitution. Countries with a history of hyperinflation are prime candidates for currency substitution, even if they currently enjoy price stability. In general, when currency substitution is widespread there is anecdotal evidence of its existence. Large DCC would be an a priori indicator of currency substitution, as would a predominance of demand deposits among the dollardenominated deposits or a well-developed dollar money market. However, in cases where dollar deposits are not legal, the banking system is not trusted or is underdeveloped (as in Indochina), or where the fear of confiscation is high, foreign currency may be demanded as a safe asset rather than for currency substitution reasons.

Choice of Monetary Target

In a floating exchange rate regime, or a fixed exchange rate regime with limited capital mobility, dollarization can affect the choice of intermediate targets of monetary policy. On the view that money is targeted because it determines the price level through transaction demand for money, currency substitution implies that dollar monetary assets are part of the relevant concept of money, whereas asset substitution implies that they are not.

The empirical literature has shed little light on the distinction between currency substitution and asset substitution in this context. Most work has implicitly or explicitly assumed away asset substitution in testing for currency substitution.22 The traditional approach has been to attempt to identify currency substitution from the coefficients on the rate of return variables included in money demand functions. Specifically, studies added a variable measuring expected exchange rate depreciation to the usual determinants of domestic money demand and interpreted this variable as measuring the opportunity cost of holding domestic versus foreign currency.23 As Cuddington (1983) pointed out, however, domestic money demand will depend on the rate of exchange rate depreciation even in the absence of currency substitution, because the rate of depreciation affects the yield of foreign assets, which is an opportunity cost to domestic money. Thus, a test to distinguish between currency and asset substitution would include both the rate of return on foreign bonds in domestic currency and the rate of depreciation itself in the money demand regression, with a negative and significant coefficient on the rate of depreciation variable suggesting currency substitution as distinct from asset substitution. Unfortunately, these two rates of return variables are closely correlated, particularly in countries likely to have currency substitution, and their independent effects are essentially impossible to distinguish.

In this light, a potentially more fruitful approach to identifying currency substitution would start not with money demand but with the determinants of inflation. Although money demand functions look quite similar to asset demand functions, and the explanatory variables that may distinguish between the two are highly correlated, it is the stock of money, but presumably not of assets, that is closely correlated with the volume of transactions and the rate of inflation. From this point of view, the relevant test of currency substitution is whether foreign monetary assets belong in the monetary aggregate that predicts inflation in the most reliable way.

Reasoning along these lines, Berg, Borensztein, and Chen (1997) used a vector autoregression methodology to examine the strength of the relationship between inflation and lagged changes in various definitions of money in Peru.24 They found evidence suggesting that aggregates that include FCD improve inflation prediction in this bivariate framework. Although broad, purely domestic currency aggregates performed worse than narrow domestic currency aggregates, broad aggregates that include FCD did better. Moreover, they found that an even broader aggregate, one that also includes CBD, is the best predictor of inflation. These results suggest that aggregates including dollar deposits might be appropriate targets in Peru. However, there is little reason to expect that this conclusion, illustrative as it is even for Peru, will be the same in each economy or that it will be the same over time, implying a need for country-specific investigation.25

The choice of a target monetary aggregate in dollarized economies is, therefore, essentially an empirical matter because it is not possible to deduce a priori the asset composition of money demand. Thus, the design of a monetary program would require an empirical investigation of the question whether the monetary aggregate that is most closely associated with the final objective—say the inflation rate—includes foreign-currency-denominated assets. Targeting the “wrong” aggregate—for example, one that excludes FCD when in fact the more stable relationship is with one that includes it—would be similar to targeting any monetary aggregate that has a loose or unstable relationship to final targets. The intermediate target variable will carry information, and targeting it will be less effective. Frequent revisions to intermediate target values would become necessary, reducing the usefulness of the monetary targeting strategy.

The choice of a monetary aggregate as intermediate target for policy should be viewed, however, from the broader perspective of finding an aggregate that provides useful summary information on monetary conditions, rather than a target to be strictly pursued independent of the behavior of interest rates, the exchange rate, or other indicators.26 While the question of the usefulness of money targeting is beyond the scope of this paper, it is worth remembering that the problem of selecting the appropriate monetary target is by no means exclusive to dollarized economies. It has proven difficult even in comparatively stable industrial countries to rely on targets for monetary aggregates in the conduct of monetary policy, and since the 1980s monetary targeting has become less and less common even in these countries. In this context, it is still to be expected that dollar deposits would play some role within the set of indicators that the central bank would need to watch in assessing monetary conditions.